Specific Issues of Economic Capital Management:Economic vs ...

Specific Issues of Economic Capital Management:Economic vs. Regulatory Capital and Business Risk

Corinne NealeManaging Director, Capital Management

© 2007 Algorithmics Incorporated. All rights reserved. 2

Communication of Risks

Active Portfolio Management

Pricing and Performance Analysis

The Pillar 1 Model

Managing IRB Capital

Capturing Real World Risks

Stress Testing

ManagementActions

RegulatoryCapital

EconomicCapital


LLN

Pillar 1: A Regulatory Model for ERM

The Stylized IRB ModelDefault/No-DefaultASRF (LLN)Hardwired CorrelationSingle Credit Driver

Lines of Credit

CreditCards

Mortgages

Commercial Medium/Small

Commercial Large

Trading BookBanking Book

Financial InstitutionFinancial Institution

Retail

Sectors

Private Firms

Sectors Sectors

Corporates(Public and

Private)

DerivativesCounterparties

Sovereign Bond Issuers

Corporate Bond Issuers

Credit Derivatives

Sectors

LLNLLNLLN


The IRB Model: Limitations

Many Risks not captured• Concentration risk

• Single name• Sector (industry, geography)

• Losses driven only by defaults,not by ratings migration

One-size-fits-all within eachBasel II-defined asset class (e.g., allresidential mortgages subject to thesame formula / correlation values;new financial products?)

Only considers one confidence level (i.e., the 99.9%)

Thus, does not address stress scenarios nortail risk (i.e., what are potential losses beyond 99.9%)

Rigidity of modeling assumptions createsdisconnect with true economic capital


Pillar II: Expectations for Risk Management

In a nutshell, the objectivesof Pillar II are to:

Compensate for limitationsof the IRB Model

Promote enterprise-widemeasurement and managementof risk

Evaluate impact of stress scenarios


The Pillar 1 Model



Stress Testing

RegulatoryCapital

EconomicCapital

Communication of Risks



ManagementActions


ERM: A Model to Evaluate Real World Risks


Quantifying the Impact of Real World Risks


0

10000

20000

30000

40000

50000

Economic Capital MacroeconomicDrivers

Correlation Impact Concetration Risk Migration Risk Regulatory Capital Capital Available

Bank ICAAP Results

Source: for this chart


Banks’ ICAAP Content

Current and Project Capital PositionsRisk Appetite:

• Confidence Interval• Horizon• Scenario the confidence level corresponds to• Risks covered by Capital

Quantification technique for each riskControl process for risks not covered by capitalRisk aggregation techniques used

• Description• Assumptions• Limitations

Details of stress and scenarios appliedControls and ICAAP validation processICAAP and Pillar 1 comparisonsInternal use of ICAAP


Quantification Issues: Concentration

How concentrated is my portfolio?

Possible answers:• HH Indexes• Ratio of largest to smallest exposures• Ratio of Additive UL to Absolute UL

this is the only one to capture correlation!

Where are the higher-aggregate concentrations?• This requires multi-level results?

How do correlations interact with concentrations?• Only a full EC model can help to articulate this


LLN

Modeling Single Name Concentration: An Example

Chart 2. A nongranular portfolio containing an infinitely fine-grained subportfolioNote: Entire portfolio (subportfolio A plus B) is nongranular

Source: Bank of Japan Working Paper Series “An Efficient Monte Carlo Method for a Large and Nongranular Credit Portfolio” Hideaki HigoSee: http://www.boj.or.jp/en/type/ronbun/ron/wps/wp06e19.htm

Nongranularsubportfolio A(# of obligors η)

Infinitely fine-grainedsubportfolio B(# of obligors η)

Where you draw the line depends on your accuracyvs performance trade-off

Sampling or FFT


Sampling SamplingFFT LLN

Lines of Credit

CreditCards

Mortgages


Commercial Large

Modeling Single Name Concentration: An Example

CP analysis

DND for derivatives

Full Migration for Bonds

Integrated Market & Credit (Stochastic Exposures)

Netting & Collateral

Impact of Credit Derivatives

CP analysis

Full Migration

Integrated Market & Credit (Stochastic Exposures) or MtM

CP/Sector analysis

DND or Full Migration

MtM Exposures

CLT

Sector analysis

DND

Notional

Financial Institution



Retail


SamplingFFT LLN CLT

A Model – Basel Granularity Adjustment

Lines of Credit

CreditCards

Mortgages


Commercial Large




Retail

Run 1 = Systemic + SpecificRun 2 = Systemic

Run 1

LLNRun 2 LLN LLN LLN


Quantification Issues: Sector Concentration

The other form is Sector concentration• “…relates to imperfect diversification across systematic components of risk,

namely sectoral factors…”*• E.g., exposure to the U.S. automobile industry, which might be highly correlated

to other sectors (e.g., energy, aluminum manufacturing, consumer finance, etc.)

Multi-factor modeling enables the full captureof correlations across industry/geographic sectors…

• Identify exposures to highly correlated industriesor geographies that increase portfolio risk

• Likewise, capture diversification benefitsthat mitigate portfolio risk

*Basel Committee on Banking Supervision, “Studies on credit risk concentration”, Working Paper No. 15, Nov 2006


Multi-Factor Modeling

Illustration: The Multi-Factor Variable – Candidates

General State of the Economy• Composite Leading Indicator• OECD_CLI• Industrial Production Index• Manufacturing Utilization rate

Prices• Producer Price Index• Producer Sales Index• Producer Inventory Index• Imports

Foreign Trade• Exports• Import Price Index• Export Price Index

Foreign Exchange• FX Rate – Euro/USD• FX Rate – Euro/YEN

Money Markets• 3-Year Corporate Bond Yields• Call Rate• Commercial Paper Rate


Sector / Geography / Business Concentrations

0

50

100

150

200

250

300

Sector 1 Sector 2Sector 3 Sector 4 Sector 5 Sector 6Sector 7 Sector 8 Sector 9 Sector10

Sector11

Sector12

FTSE classification

Million €

0

200

400

600

800

1,000

1,200

EL UL Exposure


Quantification Issues: Stress Tests

Stress-tests are part of risk management:

• Residual Risk• Marginal Risk• Business Risk• Macro-Economic Risk

• Downturn / Market Event• Liquidity risk• Correlations

What-If?

ExceptionalEvents

• Capital Adequacy• Capital Allocations• Management Actions

Sensitivities

ChangeAssumptions

TailRisk

UnderstandRisk Profile


Definition:

The risk that, as a result of an external event, some of the bank’s business expenses be not covered by the income expected from that business, resulting in a net loss that needs to be funded with capital:

Business Risk Assessment Through Stress Tests

Scenarios

Sensitivities

Loss Impact

Business Budget(Self Funded)

StressTests


Shocks toasset correlations

Stress Test 1

Shocks to credit qualitytransition probabilities

Stress Test 2

Other Risk Assessments Through Stress Tests

Illustration:

Shocks to systematic risk

Stress Test 3


Other Risk Assessments Through Stress Tests

Results:

020406080

100120140160

Stress1

Stress2

Stress3

EC Base


The Pillar 1 Model



Stress Testing

RegulatoryCapital

EconomicCapital

Communication of Rrisks



ManagementActions


ERM: Tools for Management Analysis and Action

Advanced modeling techniques enable the quantification of real world risks across the portfolio

Quantification, in turn, enables financial executives to unlock value:

• Communication internally, with regulators,and to the market about risk profile;

• Active management of the portfolio;• Pricing decisions and performance analysis; and• …Ultimately, creation of economic value and

profitable business growth


Communication of Risk


Branch

Corporate Group

Communicating Risks

Division

Subsidiary

What is my exposure and regulatory capital

for United Airlines ?

What is my exposure and regulatory capital

associated with Brazil ?

What is my regulatory capitalon the tech sector for our

Asian sub ?

Cou

nter

part

y

SIC

Cou

ntry

All

All

What is my regulatory Capital on retail mortgages

For UK division ?

What is my total regulatorycapital requirement

for the bank ?

What is my exposure andregulatory capital on

non-investment grade products ?

Type Gro

up

Gro

up


Actively Managing the Portfolio

Evaluating risk contributions across quantiles...but:• Which cut of the portfolio (sector, geography, business line)?• Which statistic (e.g., VaR, UL, Expected Shortfall)?• Which quantiles (e.g., 95%, 99.9%, 99.97%)?


Contact Us

Eric [email protected] (81) 3 5224 4436

Toru [email protected] (81) 3 5224 4437

Corinne [email protected] (65) 6536 7737

Date post:	06-Feb-2022
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Specific Issues of Economic Capital Management:Economic vs ...

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